How Small Business Taxes Work

An S corporation, or S corp, is a cross between a corporation and a sole proprietorship/partnership. It basically takes the best of both structures and combines them to offer potentially significant tax savings. Only corporations with fewer than 100 shareholders are eligible to be taxed as S corps (though some businesses, notably those in the field of finance, can never be S corps, regardless of size).

Liability

Like a C corporation, an S corp is legal entity. Owners are not personally liable for business debts.

Income Tax

Like a sole proprietorship, partnership or LLC, an S corp is not a separate tax entity, so it does not pay income tax. Profits "pass through" the company to the shareholders, so they are only taxed once. Taxable business income is reported on owners' individual tax returns.

Employment/Self-employment Tax

Owners of S corporations are also employees. They pay themselves wages, and they only pay employment or self-employment taxes on those wages, not on the company's entire profits [source: SBA].

Between single income taxation and wage-based employment/self-employment taxation, the S corp designation can result in real tax savings. Small businesses, depending on how small they actually are, might be eligible for some other tax perks, too, including:

Using the cash instead of accrual method of accounting for tracking inventory, so sales count as income when the customer pays, not when the order is placed (for businesses with less than $10 million in annual receipts) [sources: Sherman, IRS]

A lower penalty cap for late filing of information returns (forms, not payments): $500,000 compared with $1.5 million for large businesses (for businesses with up to $5 million in annual receipts) [source: IRS]

A three-year tax credit for initiating a 401(k) or other retirement plan (for businesses with 100 or fewer employees earning more than $5,000 in the year the plan is first offered) [source: Appleby]

And of course, like any other company a small business is entitled to take deductions that reduce its taxable-income amount. Some deductible expenses are obvious – office supplies, for one. Or tickets to trade shows. But others take a bit more tax savvy.

Be Reasonable

S corporations are somewhat prone to audit. Since shareholders can easily exploit the system by paying themselves almost nothing in wages and therefore almost nothing in self-employment tax, the IRS tends to scrutinize the amounts paid by S corps to their shareholder employees. If the salaries are not reasonable by industry standards, it may result in a costly audit [source: Dahl].